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Dominos Pizza Inc. (NYSE:DPZ)

Q3 2007 Earnings Call

October 16, 2007, 11:00 am ET

Executives

Lynn Liddle - IR

Dave Brandon - Chairman, CEO

David Mounts - CFO, VP Finance

Analysts

Ashley Woodruff - Friedman Billings Ramsey

John Glass - CIBC World Markets

John Ivankoe – JP Morgan

Jeffrey Bernstein - Lehman Brothers

Joe Fisher - Bear Stearns

Dan Perla - Iridian

Zafar Nazim – JP Morgan

Joe Buckley - Bear Stearns

John Staszak - Argus Research Corp.

Glen Patraglia – Citigroup

Operator

At this time I would like to welcome everyone to the 2007 third quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Lynn Liddle, Executive VP of Communications and Investor Relations. Ms. Liddle, you may begin your conference.

Lynn Liddle

Thanks Jason. Thank you everyone for joining us this morning. With us today, we have our chairman and CEO, David Brandon; our executive VP of distribution and procurement, David Mounts; and as our former CFO, David will be covering this call as he passes, for the time, onto our acting CFO, Bill Cap, who is also with us today.

We will begin with an overview of the quarter, from Dave Brandon and follow up with David Mount, and then open for Q&A.

A couple of points before we begin is, we will ask the media to be in a listen only mode, and I’ll also refer you to our Safe Harbour Statement that is in our press release and in our queue, in the event that any forward-looking statements are made.

And with that, I would like to turn the call over to David Brandon.

David Brandon

Good morning everyone, and thanks for participating in our review of the third quarter earnings. Dave and I will likely both take a couple minutes more than we normally would, to walk you through what we would expect to be a lot of areas of interest, based on the environment that we’re in and the results that we are announcing today.

Our earnings per share this quarter was $0.17, which is $0.17 less than adjusted EPS for the third quarter last year, but let me make sure I quantify this gap. The vast majority of it, $0.13 of it is due to the added interest expense from the change we made in our capital structure earlier this year, which we have covered on previous calls. We’ve had very positive investor feedback regarding our more leveraged capital structure. We actually, as we look back, believe our timing for this re-cap was very fortuitous, and we know that our shareholders appreciate the $13.50 dividend we paid in the second quarter.

So my focus today is going to be on the remaining $0.04 of earnings per share decline. This is primarily due to challenges that certainly aren’t unique to our company or inconsistent with the many topics we have discussed back as recently as our second quarter earnings call. In fact, we have been discussing these trends and issues with you for quite some time. We are managing in a very challenging domestic operating environment. This is due to continued traffic declines in our category, which are clearly a result of continued softness in consumer demand. And since both of you know how our business model works, you know that decreased traffic causes a reduction in our distribution volume, which results in a reduction of efficiency and profitability in this segment of our business as well.

We also continue to battle the cost pressures from commodities and labor that I described in a fair amount of detail during our last call. In fact, these commodities were higher at the end of the third quarter than they were at the end of the second quarter. Our operators continue to absorb very large increases in food packaging and labor costs, which have pressured us during the entire year.

As I detailed during our last call, we are doing our very best to raise prices, to reflect the impact of these historically high cost pressures. At the same time, we are trying to stimulate traffic growth in our category, not an easy task when consumers, and particularly highly price-sensitive consumers, are getting hit with food price increases at every turn and are clearly reacting by reducing their spending across many retail categories.

Thankfully, these challenges and shortfalls are somewhat mitigated by the stellar performance that we continue to get from our international group, as evidenced by this quarter’s results. We continue to celebrate the growth and progress our brand is making in so many regions of the world.

Now, we talked before how many segments, there are many segments of the QSR industry that continue to experience reduced traffic, and we see this from our third party research sources as well as our own internal data. We really believe that consumers are reacting to their tighter financial situations. Now, while our local store marketing efforts, our national marketing topics, and our store level execution were able to able to help us buck the traffic turn last quarter, our franchise needs in the U.S. didn’t gain enough momentum to carry that into the third quarter. We feel bad about that. Our team U.S.A. unit was able to list their prices at a faster rate than our franchisees, while at the same time doing a better job of minimizing traffic loss. Consequently, they were able to keep their overall same store sales slightly positive for the quarter. However, our franchisees were slower to raise prices and actually experienced a higher reduction in traffic. So we know exactly what needs to happen. We need to get our franchisees embracing the many initiatives that we have launched in our corporate-owned stores that will help them close the same-store sales gap that currently exists. We are working very hard to communicate these best practices and proven techniques to our franchisees across our domestic systems.

Now, in addition to the work that we are doing with our marketplace organization, to try to ignite the energy and power of our franchise system in the U.S., I want to assure you that we are not sitting idly by here at our world resource centre in Ann Arbor. We have worked hard to earn our reputation as a very proactive management team and we are all over these challenges. I have recently announced changes that I believe will help bring even more focus and energy, as we address our domestic sales situation.

We recently announced management changes, specifically the promotion of Patrick Doyle, the president of Dominos U.S.A., which puts a proven operator who turned around team U.S.A. stores in the right place, to positively impact our domestic franchisees and target our areas of weakness.

We also announced the transfer of David Mounts, to lead our distribution and procurement business. I believe this will be a great opportunity for David to make a positive impact on this important aspect of our business, particularly during this time of unprecedented cost inflation.

We have teamed up with a cutting edge creative agency, Crispin Porter & Bogusky. Their experience in targeting our key customer group and their spot-on assessment of our brand in the agency review process; and their knowledge of how to leverage the value of brand equity is expected to result in some dynamic changes in our advertising, which you will begin to see early in the new year.

We also continue to leverage technology through our pulse point-of-sale platform, which has now been installed in approximately 60% of our domestic stores, with new installations coming on-line every day. During the third quarter, for the first time, we rolled out on-line ordering messages on our TV and print ads, resulting in steady increases in on-line orders, which generally are more frequent purchasers and at a higher average ticket. This was a distinct plus for our corporate team U.S.A. stores, since every one of those stores has pulse and offer on-line ordering in every store. We have also added mobile phone ordering capability. This increases access to our brand and targets our core customer and how they prefer to order from our company.

We are also making progress towards rationalizing pricing. As I said, our team U.S.A. stores have worked hard to increase prices where there were opportunities, reducing unneeded discounts while optimizing coupons, purging underperforming products and underperforming promotions. We have encouraged our franchisees to do the same thing.

As I said earlier, we know that prices most increase, to cope with increasing commodity costs; but we recognize that this must be done strategically when traffic issues continue to pressure the sector. I brought this up the last quarter and likened it to dancing on the head of a pin. Team U.S.A. has taken a very measured stance towards this delicate balance and has seen a minimal fall-off in traffic, as a result of careful and considered pricing increases. So far, they are doing the best job of dancing, and we need to make sure our franchisees follow their lead.

Team U.S.A. stores also continue to be very active with their local store marketing, maintaining high levels, and this has continued to pay off. We have shared their results from these elevated local store marketing efforts with franchisees, and we have encouraged them to participate in country-wide local store marketing blitzes. There is no question about, in today’s environment, if you want to grow your traffic, you are going to steal share from somebody else; and that’s a war in battle that needs to be waged at the market and store level; and that’s what team U.S. A. is doing very effectively, and we need to get our franchisees to do better.

Our primary focus in the fourth quarter of this year will be to more effectively get our domestic franchise system to grow their sales in the existing market conditions. We cannot be successful unless our franchisees lead our success, and that’s certainly been the history of this system. Out of 10 of the last 13 years, franchise sales have exceeded corporate sales by an average of a 3% gap. If they were currently beating team U.S.A. by their traditional 3% spread, our quarter results would be much improved. It’s important to note, though, that our franchise performance isn’t the same for every store or in every market. We are discussing averages here, and I want to make sure I send a shout out to those franchisees who have continued to out-pace team U.S.A. throughout this period.

We have some very successful operators out there who are doing a great job. We are counting on them to help us lead the way to improve the performance of those who are lagging. So we are bringing heavy emphasis to close that gap and regain the historical momentum from our franchisees and our franchise system.

I want to close my remarks by once again pointing out that the big winner of this quarter was our international division, which did extremely well, hosting a very strong 8.3% same-store sales comp, their highest in over 2 years. This speaks loudly about the strength of our brand world-wide and strong engine of growth that our international division provides to this company. Our international operators are a great example of executing the fundamentals of our business well every day, and I want to congratulate them on a great quarter.

Now, with that, let me turn things over to David Mounts, who is going to take you through a more detailed look at our financial performance. As Lynn mentioned, although David has officially transferred to his new position as the EVP of Distribution and Procurement, he is handling our call this quarter, which will be his last act before we pass the baton over to Bill Capa as our acting CFO; and Bill will execute the responsibilities of this important function until we complete our national search process and fill this position permanently. David.

David Mounts

Thanks Dave, and good morning everyone. As you will note, from our earnings release we have several items that affected the comparability of our results to those of the third quarter last year. I’ll cover those shortly but first let me start with the top line.

We ask you to remember that revenues can be misleading when analyzing Domino’s financials, and ask you always consider global retail sales as the key gauge of our top line performance.

Our global retail sales increased 7.2% during the quarter. That was driven primarily by same store sales growth in our international business, and an increase in worldwide store counts of 272 units over the trailing four quarters. Same store sales domestically, our sales decreased 1.6% for the quarter. As Dave mentioned, our company owned stores increased 0.8%, that was versus a down 2.3% on the quarter three 2006, while our franchise same store sales were a negative 2%. This was versus a negative 3.2% in the third quarter of 2006.

International same store sales increased 8.3% over last year’s positive 3.0%. This was the highest growth in nearly three years and marked the 55th consecutive quarter of international same store sales growth.

Moving on to the income statement. Our total revenue revenues for the third quarter were $337.3 million, a $10.6 million of 3.3% increase from last year. It was driving by higher distribution levels revenues that were caused by the elevated food prices, mostly cheese. This benefited the DPV revenues but it contributed to lower team USA margins, which I’ll discuss a little bit later.

Additionally, we had higher revenues from our international stores in the third quarter, which was driven by the increase in same store sales and the store count that I just mentioned.

Our consolidated operating margin as a percentage of revenues decreased only 1.4% in the third quarter versus the prior year. We were at 24.9% in the third quarter of 2007 versus 26.3% last year. There was a reduction of 1.6%, based on the impact of increased cheese prices and its effect on the distribution percent margins. The average cheese block price in the third quarter was $1.95/lb versus $1.19 last year. This is a 64% increase. It’s the widest spread we have seen in cheese prices between year-over-year quarters in three years. Remember that the dollar value of margins does not change in our distribution business when cheese prices fluctuate.

Our international division’s operating margins improved with the sale of our France and Netherlands operations, which was completed in the third quarter of 2006. Also, our international franchise business, which has no cost of sales, gained as a percentage of total revenues. This helped improve our overall consolidated margin.

Our team USA margins were negatively impacted by higher food costs and also higher labor costs, but not as severely as some in our industry, at only 2.3%. This reduced our overall company margins by approximately 0.5%. The resilience of our model is clear when you consider that, if you factor out the increasing cheese cost impact on distribution, our operating margin was flat to slightly positive in this very tough cost environment.

As Dave mentioned, we are operating in an environment that is high cost and we’re working to manage those costs down on a number of fronts. As I’ve previously discussed, our team USA food costs are net of our derivative milk contracts. These contracts had a non-material impact on our third quarter financial performance and were settled in the fourth quarter. The settled contracts will not have a material impact in the fourth quarter.

This hedging strategy provided some benefit to our corporate stores in the rising cost environment we have seen over the past year. But the hedging is a not a practical tool for the overwhelming majority of our franchisees. Remember, our average domestic franchisee owns and operates three stores. So they are not inclined to want to get involved in market hedging activities.

However, in an effort to achieve the goal of lowering volatility and improving our operators’ ability to plan and budget more effectively at the store level, we entered into a new multi-year purchasing arrangement during the third quarter, with our primary cheese supplier. We believe this contract will serve to more effectively smooth out our cheese cost volatility for both our company-owned and franchise stores.

Let me turn now to G&A expense. Part of our cost containment effort is controlling G&A expenses, and we have been very disciplined about this during the quarter. Excluding last quarter’s $5 million legal reserve, and expenses in connection with our recap, we saw total G&A turning down in the third quarter compared to levels experienced during the second quarter. In case you are comparing to last year, last year’s GA number includes gains from sales of our France and Netherlands operation, and gains from the sale of our Memphis stores to a franchisee. Our bottom line earnings, our diluted EPS and report on a GAAP basis, were $0.17 in the third quarter. This is a $0.22 decline, as reported of $0.39 in the prior year period. In the third quarter of 2006 we benefited $0.04 from a $2.7 million after tax gain on the sale of the company-owned operations in France and the Netherlands.

The company’s recent recap had a significant impact on ongoing interest expense. As a result of the higher debt levels, this resulted in a decrease in diluted EPS of $0.13, as Dave mentioned. Our cash interest expense for the quarter was $23.5 million at a rate of 6.06%. Our book interest expense, related to our debt facility for the quarter, was $25.6 million or a rate of 6.6%. Our total interest expense for the quarter, including letters of credit, capital leases and accrued interest on a Fin 48 tax liabilities is $26.5 million. This was the first quarter with the full impact of our new capital structure.

This gives you a good picture of our ongoing interest costs for our 12-week quarter. Keep in mind, though, that the fourth quarter has 16 weeks. Including the effect of the items discussed above, the additional $0.04 decrease in diluted EPS was driven by lower team USA margins, about $0.02; a decrease in distribution profits from lower volumes, that was also worth about $0.02; and again, from the 2006 sale of the eleven corporate stores in Memphis, worth about $0.01. This was all set, in part, by the continued strong performance in our international operations, which was a plus of a little more than $0.01.

Additionally, our effective cash rate was 39.8% in the third quarter. This was because, during the third quarter, we recorded a $300 thousand dollar net reserve, related to ongoing state income matters. 2006 was positively impacted by a tax benefit, associated with the sale of our company-owned operations in France and Netherlands. We continue to anticipate that the normalized tax rate of 37% to38% is still a good target over the foreseeable future.

As discussed in our earnings release, the company re-purchased approximately 1.1 million shares of its common stock under the open market re-purchase program. This cost $18 million during the third quarter. These shares, re-purchases on their own, impacted diluted EPS less than $0.01 for the quarter. Our OMR program was implemented, refined and made fully operational last quarter, and we will continue to be opportunistic buyers in the market. The purchases made during the quarter, when considered on an annual basis pro forma, would impact EPS positively by about $0.02.

Let me turn to leverage. Our total debt was $1.7 billion, which represents $1.6 billion of triple-A rated notes and $100 million of subordinated notes. I remind everyone that all of our currently funded debt is fixed rate for the next five years and that only our $150 million variable note program, our revolver, is variable at a spread of 70 basis points to the commercial paper funding rate. That has tended, historically, to be close to the LIBOR 30-day rate.

We continue to be very comfortable with our new debt level and we have seen no economic affects on our current financing or on our capital structure due to recent turbulence in the credit markets. Since our rates and terms are fixed, we expect the same conditions during the balance of our five year term.

In closing, despite a challenging quarter, we continue to generate positive free cash flow and have proven that we will utilize this in a manner that is most beneficial to our company and shareholders. We remain focused on managing cost and creating shareholder value during these challenging times in our domestic operation.

This concludes the financial update, and once again, we want to thank you for your time today. We appreciate your support and would like to answer your questions.

Question-and-Answer Session

Operator

Your first question comes from John Glass with CIBC World Market.

David Mounts

John, is that you?

John Glass - CIBC World Markets

This is John Glass. Can you hear me?

David Mounts

Yea, we can hear you now.

John Glass – CIBC World Markets

Wonderful. Okay. Sorry about that to John Ivankoe. Could you help put the quarter in context of the industry in the U.S. Did you feel like you outperformed the pizza category, underperformed it, or is this sort of what everyone else has been doing as well?

David Mounts

It’s the obvious question. We, you know, we subscribe to the CREF data and it’s the best data that we have, and it’s certainly, you know, I think it’s good directional date. Our sense is that the category was totally negative as it relates to traffic growth. Everybody was trying to inch ticket up in light of it, cost situation, but we can’t see anything in the data that leads us to believe that there has been anything other than a significant reduction in consumer spending in the category, and the traffic is down across the board.

David Glass – CIBC World Markets

Okay. You talked about getting franchisees traffic better. You talked about that last quarter. Is there anything different in what you’ve seen them doing this quarter versus last quarter, or is there anything new or different in how you’re going to help them going forward, drive their traffic stronger?

David Mounts

Well, listen, the status quo isn’t working. I think some of the things we are doing with leadership changes, and some of the internal programs that we have launched and trying to excite the franchise body with some new brand positioning, and the new energy that’s going to come from advertising agency; all those things, in their own way, are a function of trying to shake things up a little bit and create some backpressure on our franchise group.

These are unprecedented times for us, both in terms of cost inflation and the fact that we’re having a hard time growing our sales. As you know, for many many years, it wasn’t a function of whether we were in positive sales, it was a function of how positive they were going to be. And one of the things we’re really trying to coach this system through is how do you react to this adversity and not do things that are detrimental to the growth of the business.

It’s not a time to be cutting back on marketing activities or cutting back on marketing spend, or cutting back on technology spend. This is the time you have to invest because it’s war out there, and whoever gets ahead of the curve is going to be the one that’s going to get the benefit. So, again, as I’ve said in my kind of prepared remarks, we’ve got a lot of franchisees who are getting it right. They’re growing their sales in this period and they’re doing well. We just don’t have enough of them; and that gap that exists between the franchisees and team USA right now is the elephant in the room, and we’re going about the business in every way we know how of getting that fixed.

David Glass – CIBC World Market

I see. Now just one last question, David Mounts, you had mentioned a cheese contract. Can you talk about any details? Is it an absolute price or is it a collar? You know, how much volatility should we still expect in cheese prices with this contract in place?

David Mount

Yea, we think the volatility, the only way I can really answer that because the nature of that contract is that it’s confidential, John; but I can give you a sense for volatility. We think the volatility would be down about a third.

David Glass – CIBC World Markets

Okay. Thank you.

Operator

Your next question comes from John Ivankoe.

David Mount

John, can you hear us?

John Ivankoe – JP Morgan

I can hear you fine. Yes. You know, what has been the hesitation of franchisees to reduce discounting or take pricing in the third quarter? I mean, it would seem like it would be a fairly simple action, I mean, so what has really been their push-back from their perspective? Why do you think they haven’t done it as quickly as team USA has?

David Mount

Well you know, I’ve got 1,275 answers to that question.

John Ivankoe – JP Morgan

Okay.

David Mount

Again, there are people who have done it well; there are people who have done it better than team USA, but we have a lot of smaller operators out there who, you know, have kind of a historical reflex and have been in a pattern of behavior. And what we’re finding is, in these highly unprecedented times, it’s more difficult than I thought it was going to be to get them to understand that they have to really significantly change the direction of how they’re marketing in their local market area.

John Ivankoe – JP Morgan

Okay.

David Mount

And so it’s taken longer than I thought it was going to take. It’s a bigger challenge than I thought it was going to be, and truthfully the target keeps moving because it seems like, ah, you know, the cost pressures continue to spiral in a upward direction. Frankly, at the end of the second quarter I didn’t believe it could get any worse.

David Mount

Yea.

David Mount

When I look at the commodity charts, and it’s gotten worse.

[TECHNICAL DIFFICULTIES]

-- was increased from $3.00 to $3.50 a bushel at $9.00; and it happened remarkably fast in a period of a short number of months. Now I’ll turn things over to David and he can tell you what the implications of that have been to our distribution centers and, in fact, our operators.

David Brandon

Yes. John, we, you know, we have been on a cycle where we have set pricing on our wheat on an annual basis historically, because it hasn’t, there hasn’t been much variability, and it’s worked out well for everybody. We buy about 5.5 million bushels of wheat a year; so every time the price changes a dollar on a bushel, you know, we’re gonna feel a $5.5 million impact, both us and our franchisees in our distribution system the way it works, because of the profit share. So, you know, when you start to compare those price changes, you see a larger impact.

One of the things that we will have to implement next year is we will have to go to more frequent pricing during the year. We think that quarterly pricing makes the most sense at this stage but we’re going to continue to evaluate all our options. For sure, we will not be going with annual pricing and distribution, so we won’t be in a situation where we were this year, where we had pricing in place for the year.

We made the decision, you know, given all the other price changes that are impacting our franchisees, not to go in and amend prices mid-year, because our franchisees have built their budgets and their plans based on what we told them pricing was going to be on dough balls for the year. So we’re taking, especially in this last quarter, we’re taking an impact here that, you know, we didn’t anticipate and wasn’t planned; and, of course, some of that impact is also absorbed by our franchisees in their rebate payments. But, you know, we clearly have to get, you know, in an environment like this we have to get to a more frequent adjustment of pricing and let these costs more flow through, like we do with our other commodities.

John Ivankoe – JP Morgan

Okay. I definitely did notice, the distribution income was absolutely lower than what we thought it was going to be. What was the primary contributors to that?

David Mount

Wheat was the primary contributor to that.

John Ivankoe – JP Morgan

Okay.

David Mount

You can see that again, John, in probably even more, a little more exaggerated than even the third quarter, because we had some forward purchases that shielded us for part of the third quarter. You know, we’re not going to have as much coverage in the fourth quarter, so we’re going to see an even more exaggerated impact. And then, when it comes to reprice at the beginning of the year, we should be able to re-set most of those, you know, back into what’s been customary.

John Ivankoe – JP Morgan

It’s kind of a bigger question but again, we talk about dough balls and cheese, I mean, the franchisees really are feeling a lot of pressure. I mean, have they really begun to push back on you, saying hey, your know what; we know we share in half of the distributions profitability, you know, we think that number is, you know, should be greater? In other words, are the franchisees trying to take from the corporate now, you know, versus, you know, trying to make money from the customers, if that’s a good question?

David Mount

John, that’s the end of the case. We, you know, we have, our distribution business is managed and the structure is set up where there is absolute alignment between us and the franchisees. We have franchisees that serve on our distribution advisory board, they are involved in and they understand the realities of the business and how they’re affecting us, and they are part of that decision making process. And it has been historically, and will continue to be, a very collaborative process, you know, with both sides incentivized to try to grow distribution EBITDA in ways that manage the supply chain more efficiently.

John Ivankoe – JP Morgan

Okay, very good. And a final unrelated question from me. You know, the cash balance is, from my opinion, high, given what your free cash flow yield. I mean, could you explain why that is, I mean, what that for our credit agreements and, you know, is it possible to assume that all of your free cash flow in the future will be used to buy back stock, or is there a necessity to put aside more funds for the debt holders.

David Mount

No, you’re certainly seeing, you’re seeing an abnormally high, it’s a very good question John. We’re sitting with $115 million in cash. The way that breaks down, about $100 million of it is tied just into the ABS in terms of reserves and, really, timing of the interest payment. Let me walk you through a breakdown of the core of that $115 million. $15 million had to be set aside as a capitalized, in the new franchisor entity, to quality for the uniform franchise exemption; so, in other words, that we can continue to franchise throughout the country as a well-capitalized franchisor. So that is a one time increase in capital and in cash that is, at this point, appears to be permanent; but we’re going to evaluate that over time and see if other assets also could qualify for that exemption.

But right now we think it’s mostly cash. We have $55.2 million that’s set aside right now for our interest payment that we’re going to make on October 25. Remember that the ABS interest payments are quarterly, based on a calendar basis; and, as you know, we have, you know, 12, 12 and 16 in terms of our quarters. So you end up with a little bit of a time difference; and on October 25 we’re going to write a $55.2 million cheque to our note holders for all the interest that was due them for the pro-rated second quarter and all of the first quarter. We also have $26.9 million that is set aside in interest reserve, basically the equivalent of a little more than one-quarter’s payment, to the note holders; and that was really kind of a cushion set-up in the structure that was to be evaluated after the first two quarters of interest payments.

The way that reserve works is it’s measured against the debt service coverage ratio; and we compare where we are in actuality to the DSCR measurements, and as long as we are over 2.7, which we fully anticipate that we will be, in terms of that calculation, then two thirds of that cash will be freed up and we’ll only have to keep one month’s interest reserve on file. So part of this is just timing in terms of, you know, getting through the first quarter and getting the first payment made; it’s part of its timing in a new structure where everybody wants to make sure after it’s implemented, that all the pieces feel into place, like everybody thought they would, and that reserve will be reduced appropriately after the new year.

So those are the two main things, and then this new franchise unit. So, when you take those into account, you’ve really only got about a little over $15 million left, which is probably more typical; and you should expect to see us use that cash when it becomes available, from the reserve mechanism, and you should expect to see us continue to use cash flow to pay down our, and to buy back our stock, rather.

John Ivankoe – JP Morgan

Okay. All right, that’s a great answer. Thank you so much for that.

Operator

Your next question comes from Jeffrey Bernstein

Jeffrey Bernstein - Lehman Brothers

David Mount

Jeff, are you there?

Jeffrey Bernstein - Lehman Brothers

Yes, can you hear me?

David Mount

We can. Go ahead.

Jeffrey Bernstein - Lehman Brothers

Yes. Just first, the, kind of a bigger picture industry question. You mentioned CREF data and the impact on consumer spending. I was just wondering how you believe that the pizza category’s position relative to some of your other QSR peers; and they had mentioned that, and of course the pizza category, and in another comment you said, you know, it’s more across the board including more traditional QSR peers. I feel like, I have the feeling that that pizza category is tracking more with casual dining whereas some of your quick service peers are performing better. Just wondering kind of how you think about pizza versus the more traditional fast food in this environment?

David Mount

Yes, Jeffrey, it’s a great question and we spent a lot of time looking at that. There is no question about the fact that has been, at least if you look at the CREF data, that there has been somewhat of a deceleration in traffic across QSR; but overall QSR has still grown at a 1% to 2% rate in terms of transactions; and most of the growth is coming from party chat. But our assessment of the situation is a lot of what you outlined.

When you look across total QSR, which includes the lunch day part, the breakfast day part, sandwich guys, people who seem to be operating in the party check mode of $6, $7, $8, which is kind of the overall average for QSR, the ones that are at the low end of that average check range seem to be doing better; the lunch guys, the burger guys, the breakfast folks; and those of us who are operating at the $16, $17, $18 average checkout, we seem to be having the most difficulty in this environment, and that’s pretty intuitive when you consider kind of how the consumer is behaving and what their grocery bill is now when they’re going off and buying groceries in the grocery store, and the situation with their variable rate loans, and all the other things that we’re reading about.

You know, those folks who are operating at the higher end of the ticket range are probably going to be more impacted than the guys who are offering value menus at lunch at very low ticket.

Jeffrey Bernstein - Lehman Brothers

I think it’s pretty obvious that I get for $16 to $18 feeding a few people, whereas $6 to $8 is probably feeding one, whether there’s a way to somehow kind of reposition in a tough environment, focus more on individual servings or whatever best works, kind of bring someone in that might not be looking to feed three or four but rather just one.

David Mount

Well, listen. Value, we still have a great value message. You know, let’s face it, for less than $20 you can feed a family of five oftentimes, with some of our bundled deals. It’s still a great value message and, you know, we typically do reasonably well during these times. But in the past, when we’ve had these times of traffic slowdowns, one of the tools that we reach to very quickly is to stimulate consumption, stimulate trial by going out and shouting value in a very very bold way. That’s difficult to do when virtually every commodity that you’re buying is at a ten year historical high.

And so part one of the tough conundrums that we have right now is that the easiest level for us to pull is a difficult one for many of our operators to pull the stimulae traffic, because we are in a very very unusual unprecedented cost environment. So the dancing on the head of a pin part of it, how do we shout value and how do we get the attention that stimulates an activity in terms of traffic in an environment where we’re getting, you know, bombarded with cost increases. This too will pass. You know, I don’t think that there’s any element of this that we can’t work our way through and that we’re not working our way through. But it’s a tricky set of issues.

Jeffrey Bernstein - Lehman Brothers

Specific to those cost pressures, just a clarification, you mentioned the multi-year purchasing agreement pertaining to the cheese; and I think that you’ve got to know that, I guess, volatility would be a third of what it has been, is that, just trying to figure out when you say a third, does that mean if cheese prices are up 50%, you have a year that you can kind of mitigate that to the point that it’s really only up a third of that when your franchisees have to go do purchasing, or how do you, what does really mean, a third in some of the…

David Mount

Yes, without getting into details and violating kind of our agreements with our supplier, I would just tell you that the whole objective of that was to put ourselves in a position when cheese prices spike high, as they’ve shown a propensity to do in the most recent past, we’re not going to experience as high a rise. And then when cheese prices settle back, which they will because they always do, you know, obviously at that point we’ll be paying a premium to what we did in the past; but we’ve eliminated about a third of that roller coaster ride that could be very difficult for our operators to plan around.

Jeffrey Bernstein - Lehman Brothers

You eliminated a third or you got it down to a third?

David Mount

It’s eliminated a third.

Jeffrey Bernstein - Lehman Brothers

Got it.

David Mount

There will still be volatility. There’s no way to avoid that.

Jeffrey Bernstein - Lehman Brothers

Yep. Okay. And then just, actually one other thing. You mentioned the franchise disparity. I’m just wondering what the commonalities are, if any, in terms of why some are performing better than others. Is there, do you see an overwhelming geographic strength or weakness in any areas, or is it it’s working for some but isn’t working for others?

David Mount

We really don’t and we’ve looked at all of those correlations. It’s not geographic, it’s not urban versus rural, it’s not large operator versus small operator. It’s all based on, frankly, the passion and the execution at the store level. And our job, and we understand it, it’s been our job for 45 years, is to get our franchisees all on the same page with the tools in their hand that allow them to be successful and keep them passionately moving in the direction of growing their business.

It’s not enough just to give them a store concept and, you know, list of operating guidelines and a brand and some advertising support. We’ve got to get them waking up every morning and going to the stores that they own and putting the teams in place and engaging with their customers and executing against the business model at a level that supersedes what their competitors do in that market. It’s hand-to-hand combat, particularly in this environment; and our job is to make that happen. And obviously, in the environment we’re in, that’s one of those “says easy” “does hard” kind of things; but it’s something that we’re good at, we’ve shown the ability to do in the past, and we’ll get it fixed.

Jeffrey Bernstein - Lehman Brothers

I know you had mentioned, I guess, the new ad agency and whether you gave you an early diagnostic to say this is direction might take it in that’s different from what you have been doing, or..?

David Mount

Yes, you’re going to see a remarkable change in our brand focus starting the beginning of the year; and, you know, obviously we’re not going to telegraph that at this particular time it’s still a work in process. But I can tell you that if you really sit back and look at kind of where the category has been operating, we’ve all been launching our limited time only offers and putting spends behind the, you know, kind of, this product and price focus. If you really look at how that’s performing, and certainly the environment we’re in right now, nobody is using that to really drive traffic and sustain any growth.

So we’re looking at something that we can own and execute against and sustain at a higher level, than just in-and-out items kind of habit that everybody’s developed; and we’re kind of anxious to get that moving and more to come early next year.

Jeffrey Bernstein - Lehman Brothers

Great, thanks very much.

Operator

Your next question comes from Glen Petraglia – Citigroup

David Mount

Glen, go ahead.

Glen Petraglia – Citigroup

Dave, I was hoping you could, and I know this is a question that’s come up on past calls; but, you know, clearly your franchisees have, you know, scaled back their local market initiative; and I’m wondering if you need to change the break-out of the ad dollars in terms of how much are allocated for local versus national market?

David Mount

Well, we have. I don’t know when we last talked about this but, as you recall, you know, we got into, I think we got into a bit of a trap where we believed the more money we had in Ann Arbor to spend at the national level, the better that was going to be. We found that there’s probably, like everything else, a point where, you know, too much is too much; and I think what we did is we began to bring too much of the accountability and too much of the marketing focus in a centralized environment in Ann Arbor, and that’s not good.

So, as we go into 2008, there is going to be more balance in the marketing budgets and there will be more dollars available at the local market level, to give resources to the franchisees around their local market, to be able to engage in things that they think will be more applicable to their business and their competitive set; and I actually think that’s a positive thing. So, 2008, the media calendar will still be filled with many many weeks of national television and national offers; and in support of some of the things that Crispin is working at, but Crispin will also be developing tools that will be administered at the local level in a marketing way, to allow our franchisees to do things that they think will work in their business, and that’s a good thing.

Glen Petraglia – Citigroup

Okay, and David Mount, in terms of your new role, given your background at UPS and knowing that everybody there has quite an operations focus, you know, what sort of efficiencies do you think you can bring or that you’ve seen thus far, that would enable you to squeeze this zone a little bit more?

David Mount

Yea, you know, it’s a great question and it’s one that I’m looking forward to getting in and digging in and finding opportunities. As you probably appreciate, I’ve kind of got one foot, as we wrap up this quarter in finance, and one foot into my new job. My focus right now is on leading my team and understanding the challenges that they have and where I can be helpful to them; and I haven’t come to any conclusions, you know, at this point, but really doing a lot of listening and learning. And I think that will be the focus for the while. As we find opportunities, you know, we’ll communicate those to you, and Dave will communicate those to you on subsequent discussions.

Glen Petraglia – Citigroup

Okay. And just lastly, most of my other questions have been answered already. What sort of, what percentage of your orders are coming on-line now and how have you seen that change over the course of the last couple months, since you’ve begun to comment on on-line ordering opportunities?

David Mount

Yea, I want to be responsive without giving anybody the keys to the kingdom. I would just tell you that if the stores that have had on-line ordering the longest are showing a propensity or getting that mix into the double digits, which we think is, you know, meaningful and important, and there is a fair amount of variability, depending on the demographics of that store’s location; but what we see is that this is a material channel for many of our customers who enjoy ordering that way.

If and when we get to that double digit mix mode, it does very good things for our business. Team USA being further down that track, certainly some of the benefits that we’re seeing in terms of their execution and their sales growth, we believe is attributable to that.

We also have seen that in some cases there are tactics we can use to drive that number, and we’re doing some interesting testing and getting some interesting results from that as well. But beyond that, we just do not talk about what we’re doing there because some of it we’re pretty excited about and none of it we want to share with our competitors.

Glen Petraglia – Citigroup

Fair enough. Thank you.

Operator

Your next question comes from Ashley Woodruff with Friedman Billings Ramsey.

David Mount

Go ahead Ashley.

Ashley Woodruff - Friedman Billings Ramsey

Hi, can you hear me?

David Mount

Yep.

Ashley Woodruff - Friedman Billings Ramsey

Okay. Could you talk about, you know, I guess the transition you’ve seen throughout the year where you, you know, kind of entered the first quarter with positive traffic, the second quarter, you know, positive, and then obviously things dramatically slowed down in the third quarter.

Can you tie that, I mean, did it really trend kind of exactly with what the overall pizza, or fast food data that you have for CREF showed, or did you see a real change based on, you know, what your current promotion was. They have a follow-up on that. Can you talk about how you feel about the pipeline and really, how you feel about how the promotional pipeline has been over the past, you know, 12 to 18 months in general?

David Mount

Yea. First of all, we did not have positive traffic in the first quarter this year. We had negative sales. Domestic was negative 2.9 and it was negative traffic in the environment for us. In the second quarter we had positive sales of primarily ticket. Just a little bit of traffic but mostly ticket. And then, you obviously know the situation in the third quarter. The CREF data would lead us to believe that if you go back to basically the middle part of 2005, that the vast majority of the growth that has occurred in the category has been ticket.

In fact, CREF would tell you there has only been two quarters since the middle of 2005 where there has been traffic growth. One was 1% growth and one was 2% growth. Now, again, CREF can only do what CREF can do. This is a big category. We have some 59,000 pizza shops and CREF is not in a position to be able to be able to really have their finger on the pulse of exactly what’s going on. But directionally, I think it’s good guidance and it tells me that the whole traffic growth situation has been one that has been somewhat structural in the recent past in the category, and everybody has been kind of living off ticket. So when you keep moving the ticket up on your customer and then your customer starts cutting back in their spending as a result of some of these most recent factors, and you’ve got cost pressures, which make it difficult to go more value than you’re already at, you kind of see the world that we’re navigating through.

CREF would show that the party check average, if you go back and you take a look at really the last five years, that the guest check average in the pizza category has increased about $2.5. And if you back and you looked at the, you know, that’s the implementation of delivery charges and that’s growing the business through check and opposed to traffic. And I think what’s happening is the consumer has to catch up with these new price points. Price points will continue to move but we’ve got to be creative enough in the context of all that, to figure out a way to continue to generate some new interest in the brand and some traffic in our store; and probably, in the current environment, as I said earlier, that’s going to come from taking share from somebody else and winning the battle at the local level, than it is anything that’s going to dramatically change the current status of the category.

Ashley Woodruff - Friedman Billings Ramsey

In the promotions that you’ve done, have you seen a similar kind of mix in terms of order incidents to what you saw, say a couple years ago, in, you know, some of your stronger promotions or..?

David Mount

Yea, interestingly enough, the limited time only promotions that we’ve put out there this year have, for the most part, achieved mixed levels that were very typical with objective, very typical with test market experience; and so we don’t think the products were bad or poorly accepted or didn’t have good re-purchase. In fact, they did exactly what they did in tests, in terms of achieving mix. So people saw the commercials, they reacted to them, they tried the products, they re-purchased the products. All that is fine but what isn’t fine is it isn’t driving traffic, it isn’t bringing people into the category that weren’t there before. And that’s the remarkable change, I think, over the last year, year and a half, with a lot of the limited time only’s; and when I see what the folks are doing at Pizza Hut and Papa John’s, I get the impression that they’re in the same situation. We’re all inventing the latest twist on pizza toppings or the latest brand name to put a limited time only offer; but it sure doesn’t seem to be driving category growth for any of us.

Ashley Woodruff - Friedman Billings Ramsey

Okay. And then shifting to the franchisees, I think you used to say, maybe this goes back a couple of years, that the average EBITDA margins for a franchisee is, after royalties, right around 10% to 11%. Where is that trending on average now, given all the, you know, cost pressures that we’re seeing this year.

David Mount

Well, we rolled up all the P&Ls from 2006 because, obviously, we won’t know this year’s results until we roll them all up, you know, several months, into next year. But, as we looked at the impact of 2006 and the fact that it was a negative sales year for us, the first one in 13 years, the average franchise store incurred 0.5 point EBITDA margin hit. So that’s negative, that’s bad, that’s inconsistent with our objectives but it still puts our operators in a cash-on-cash return mode that, you know, explains why people are still out there building stores and why people are still committed to the business. It’s still a great business, it’s still a great business model; but, you know, obviously we want margins to expand, we don’t want them to contract, and the way to do that is to get more traffic and sales through the front door.

Ashley Woodruff - Friedman Billings Ramsey

Okay, and then just one last question on, you know, use of cash for shares purchase versus debt paydown, I think, you know, your inclination originally was to buy stock, at least in the first couple years at this new facility. But, given the market, I think, pretty significant sentiment shift, against companies with a significant amount of debt. Has that changed at all your thoughts in terms of the timing of paying down your debt.

David Mount

No, no, we’re very comfortable with our capital structure, extremely comfortable; and we purposely left room and got an authorization to repurchase stock; and we’ve said all along we’re going to be opportunistic; and based on what I’m seeing on my screen today there is plenty of opportunity to take advantage of people who don’t get the long term view.

Ashley Woodruff - Friedman Billings Ramsey

Okay, thank you.

Operator

Your next question comes from Joseph Buckley with Bear Stearns.

Joe Buckley - Bear Stearns

Could you quantify the pricing you’ve taken at the company stores and maybe talk about how much you have taken versus what you think the franchisees have done so far?

David Mount

Yea, Joe. As you know, we have been very reluctant and I think for a good reason, to not get into specifics about ticket versus traffic and what those numbers are; because, frankly, I’d love to have that for my competitors and follow those trends. I would just tell you that, kind of the phenomenon that we’re dealing with, which is just inconsistent with historical norms, is that in the third quarter team USA took prices up higher than our franchisees and had a lower reduction of traffic growth. Now, make no mistake about it, team USA had negative traffic, as did our franchisees, but to a lesser degree; and their ability to raise increases faster than the amount of negative traffic they experienced was what allowed them to be positive for the quarter. Our franchisees did not take as ambitious and as aggressive, and as what I would consider to be strategic and tactical approach for raising prices. And, in fact, their traffic fell further.

Now, that gives us a great story to tell when we go out to our franchisees and say, let us show you how we got more price in the business, which is exactly what this current situation calls for. At the same time it doesn’t have to be detrimental to your traffic. And so that’s what we’re fast at work doing. You know, Patrick Doyle is on the road right now, meeting with franchisees, sharing that information. So, we feel like, you know, there is a way to get there and we’ve demonstrated that; we’ve got to communicate it; we’ve got to implement it and execute against it. But again, we do this as a short term challenge that we’re working our way through, that will have a good long term result.

Joe Buckley - Bear Stearns

Okay. The question on the global retail sales number, how much was that influenced by currency during the quarter?

David Mount

Yea, for the total company it’s about 2% overall. There is about a $25 million FX in terms of the currency.

Joe Buckley - Bear Stearns

Okay. Then, lastly, this may be kind of a moot question with the new cheese contract but will you be hedging again in the future or will the new cheese contract kind of negate the need to do that?

David Mount

Yea, the lower volatility, you know, in the new contract, will negate a lot of the need to do it. I wouldn’t say we would never hedge again. You know, we always like to keep a tool box open and put all the tools in there we can; but clearly, with this new structure, there is a lot less need for that.

Joe Buckley - Bear Stearns

Okay. Very good. Thank you.

Operator

At this time there are no further questions. Are there any closing remarks?

David Mount

Well, my only closing remarks are to make sure I emphasize during these challenging times that I want to emphasize the strength of our business model. If Lynn would have let me, I would have put a headline on our press release that said, you know, takes a beating and keeps on ticking, because we continue to generate cash and we continue to do very well in a very very difficult environment; and I think it does speak to the strength of the business model.

Our total operating margins remained relatively stable at about $85 million, which is only down 2% from last year’s level; and in the environment we’re in, we just think it speaks very very hard and fast to the strength of our model and, in fact, why this business has prevailed and succeeded over such a long period of time.

So we continue to be very committed to fix what’s broken and get momentum back in our domestic sales and get our franchise business ignited, and I’ll look forward to giving you an update at the end of our fourth quarter.

Thank you all for your time and interest in Domino’s Pizza.

Operator

Ladies and gentleman, this does conclude today’s conference call. You may now disconnect.

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Source: Dominos Pizza Q3 2007 Earnings Call Transcript
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